Higher Interest Rates & What That Means For House Prices

According to Oxford Economics, "Home prices could drop by 24% by mid-2024." That would take us back to prices never seen since... 2021 (probably). We've been hearing about the coming housing market crash for quite some time and when an asset class shows this much resilience, even in the face of a global pandemic, it's hard to argue against it. Yes, we have seen minor corrections along the way, but the pandemic sparked a move, which resulted in one of the largest wealth transfers we have ever witnessed.

Across the border, real estate demand is just as hot, but ever since this article from Bloomberg came out, things haven't quite been the same for the housing market.

An analysis by KeyBanc Capital Markets, showed that the majority of homes being offloaded by Zillow, were priced below the purchase price at which they were acquired. Unfortunately, things didn't quite play out the way they had anticipated, and while algorithms are fantastic for predicting your next Google Search, Netflix recommendations and TikTok videos, the housing market has a bit more variables at play.

Aside from the company's share prices halving, maybe they were onto something? Who could blame them for trying, at a time when you had easy access to capital at record low interest rates, betting on asset prices rising sounds pretty reasonable (provided it all remains that way). But what we are experiencing now is a shift in some of those variables, particularly with the rise in the cost of borrowing:

30-Year Fixed Rate Mortgage Average in the United States:

At the time of writing, mortgage rates in the U.S. have increased by about 2.00% in the past 4 months alone. This comes at a time when the Federal Reserve is (said to be) reducing their purchases of mortgage backed securities and starting their rate hiking cycle.

The Federal Reserve has been "talking" about increasing interest rates for a while now (don't say they didn't warn you) and we've had the luxury of low rates for the past few years, but when you have these types of sharp increases to borrowing costs, especially at a time with high inflation, things can get messy.

We were told inflation would be "transitory" and unless you have not had to buy groceries or fill your car up at the gas station, you would have noticed that prices have been increasing and have not come back down. I can't help but wonder if those who have recently purchased, with the expectations that they could commute (or work from home forever), are feeling a bit nervous, as the cost of living and the cost of borrowing increases simultaneously, especially at such a rapid pace.

"Rising prices of necessities could rotate consumers spending on non-necessary expenditures such as tourism, eating and drinking establishments and purchasing clothing, footwear, and jewelry to name a few."

Now that is not to say that people who have purchased homes are in trouble, or that the cost of living will remain high forever, but with supply chain disruptions, we could be forced into reversed globalization, bringing back local production. This could increase the cost for previously imported goods, if they are to be produced locally.

This is important because mortgage repayments are made from disposable income, and unless your wages are increasing at the same pace and rate as goods and services are increasing (they're not) then as purchasing power erodes, the proportion of expenses outweighs the increase in earnings (very high level, assuming we are not dipping into savings).

But don't we all have excess savings?

We are often told that by hoarding cash, you lose money due to inflation eating into purchasing power, which has been one of the main drivers for the influx of capital into assets (namely real estate and equities), hence why prices are now at an all time high. As prices increase, home owners are stretched further, as the size of their down-payment is proportionately higher (assuming this is made from their savings, which reduces their savings for a rainy day) and in most cases, increases their size of their loan, which then increases their exposure to interest rate movements.

The good news is, rates are still relatively "low" over the long term, and we are still quite a distance from those historical levels:

If the cost of capital continues to increase, there will need to be an adjustment to asset prices, because the yield won't make sense for the average investor. If the servicing costs of a mortgage significantly outweighs the income from that investment, then it is a matter of how long that investor can hold onto that investment, until it no longer makes sense for them (provided they purchased an using leverage and aren't holding on for future development).

Of course, with higher inflation, there is a tendency for investors to flock to hard assets, and that has been one of the arguments, as to why house prices will remain resilient. The other argument is that there is a shortage of supply and although these are valid arguments, it is important to note, one of the reasons why real estate has been attractive was due to the capital gains experienced over the past few years. But those levels of appreciation are unlikely to be repeated in a credit tightening cycle, and as cap rates are adjusted, so will prices (which should improve inventory).

Every investor has different risk parameters, goals and thresholds. Unfortunately it may be the "mom & pop" investors that will be hit the hardest if things were to take a dramatic turn for the worse, as they won't necessarily have the deep pockets that institutional investors have, to ride things out.

With anything in life, nothing is certain and we could even see inflation and rates ease. At the start of the pandemic, I expected the worst. I definitely did not have my money on asset prices rising at the rate at which it did, it was all doom and gloom from one economic outlook to another. But in hind sight, if money is created out of thin air, it had to go somewhere:

Money Supply M1 in the United States

Hindsight is always 20/20, what is interesting however, is seeing similarities between what is unfolding today and what occurred during the 1970's, when economies entered into a period of stagflation with the following traits:

• High oil prices ?
• High inflation ?
• Recession (we'll get to that shortly)

Although the world today is vastly different from the world in the 1970's, there are some aspects that are eerily similar, particularly with inflation rising as a result of an energy supply shock, driving up production costs and ultimately, forcing interest rates higher. Milton Friedman criticized the central banks for not acting more aggressively to tackle inflation (sound familiar?) and if history is to provide any indication for what comes next:

I know what you may be thinking:

Aside from that, we've also heard the word "recession" being thrown around and a lot of economists thought that the Covid-19 pandemic would force the global economy into a state of despair. It seems we are now at the end of the pandemic (fingers crossed) and the economy seems to have come out unscathed. But one interesting indicator that has popped up:

Peter Chatwell, head of multi-asset strategy at Mizuho Bank, points out what a lot of us may be thinking: "The Fed’s policy response is going to put the brakes on economic growth sharply.”

Although these indicators cannot predict with 100% certainty, and to many, this may just be considered fear-mongering. What is clear is that there are shifts happening, and if sustained, something (somewhere) will eventually break.

How the Federal Reserve reduces their balance sheet, proceeds with their rate hiking cycle, while tackling inflation, without hurting the housing & equity markets, is going to be a challenge at best. Trying to predict the future however, is a fool's game and all we can do is mitigate our risks and limit our exposure to those said risks.

I don't claim to know how it will play out and there is no certainty that there could be another global event that could change the dynamics of everything in a few months time. It's important to remember that during times of uncertainty are when opportunities arise. And if history is any indication of what comes next, the world will continue to exist and we will continue to adapt. Thank you for reading.

Disclaimer: All opinions, articles, and/or information provided, reflect my personal views and is not intended as investment advice or recommendations.